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Financial Reporting and Analysis

Chapter 1 SolutionsThe Economic and Institutional Setting for Financial Reporting

Problems

ProblemsP1-1. Demand for accounting information

Requirement 1:a) Existing shareholders use financial accounting information as part of theirongoing investment decisionsshould more shares of common or preferred stockbe purchased, should some shares be sold, or should current holdings bemaintained? Financial statements help investors assess the expected risk andreturn from owning a companys common and preferred stock. They areespecially useful for investors who adopt a fundamental analysis approach.

Shareholders also use financial accounting information to decide how to vote oncorporate matters like who should be elected to the board of directors, whether aparticular management compensation plan should be approved, and if thecompany should merge with or acquire another company. Acting on behalf ofshareholders, the Board of Directors hires and fires the companys top executives.Financial statement information helps shareholders and the board assess theperformance of company executives. Dismissals of top executives often occurfollowing a period of deteriorating financial performance.

b) Financial statement information helps potential (prospective) investorsidentify stocks consistent with their preferences for risk, return, dividend yield, andliquidity. Here too, financial statements are especially useful for those investorsthat adopt a fundamental approach.

c) Financial analysts demand accounting information because it is essential fortheir jobs. Buy-side and sell-side analysts provide a wide range of servicesranging from producing summary reports and recommendations about companiesand their securities to actively managing portfolios for investors that prefer todelegate buying and selling decisions to professionals. Analysts rely oninformation about the economy, individual industries, and particular companieswhen providing their services. As a group, analysts constitute probably the largestsingle source of demand for financial accounting informationwithout it, their jobswould be difficult, if not impossible, to do effectively.

d) Managers demand financial accounting information to help them carry outtheir responsibilities and because their compensation often depends onfinancial statement numbers like earnings per share, return on equity, return oncapital employed, sales growth, and so on. Managers often use a competitors

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financial statements to benchmark profit performance, cost structures, financialhealth, capabilities, and strategies.

e) Current employees demand financial accounting information to monitorpayouts from profit-sharing plans and employee stock ownership plans(ESOPs). Employees also demand financial accounting information to gauge acompanys long-term viability and the likelihood of continued employment, aswell as payouts under company-sponsored pension and health-care programs.Unionized employees have other reasons to demand financial statements, andthose are described in Requirement 2 which follows.

f) Lenders use financial accounting information to help determine the principalamount, interest rate, term, and collateral required on loans they make. Loanagreements often contain covenants that require a company to maintainminimum levels of various accounting ratios. Because these covenants containaccounting ratios, lenders demand financial accounting information so they canmonitor the borrowers compliance with loan terms.

g) Suppliers demand financial accounting information about current andpotential customers to determine whether to grant credit, and on what terms.The incentive to monitor a customers financial condition and operatingperformance does not end after the initial credit decision. Suppliers monitor thefinancial condition of their customers to ensure that they are paid for theproducts, materials, and services they sell.

h) Debt-rating agencies like Moodys or Standard & Poors help lenders andinvestors assess the default risk of debt securities offered for sale. Ratingagencies need financial accounting information to evaluate the level andvolatility of the companys expected future cash flows.

i) Taxing authorities (one type of government regulatory agency) use financialaccounting information as a basis for establishing tax policies. Companies orindustries that appear to be earning excessive profits may be targeted forspecial taxes or higher tax rates. Keep in mind, however, that taxing authoritiesin the United States and many other countries are allowed to set their ownaccounting rules. These tax accounting rules, and not GAAP, determine acompanys taxable income.

Other government agencies are often the customer. In this setting, financialinformation can serve to help resolve contractual disputes between thecompany and its customer (the agency) including claims that the company isearning excessive profits. Financial accounting information can also be used todetermine if the company is financially strong enough to deliver the orderedgoods and services.

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Financial accounting information is also used in rate-making deliberations andrate monitoring of regulated monopolies such as public utilities.

Requirement 2:Student responses will vary, but examples are shareholder activist groups(CalPERS), labor unions, and customers. Shareholder activist groups demand financial accounting information to help

determine how well the companys current management team is doing, andwhether the managers are being paid appropriately.

Labor unions demand financial accounting information to help formulate orimprove their bargaining positions with employer companies. Unionnegotiators may use financial statements showing sustained or improvedprofitability as evidence that employee wages and benefits should beincreased.

P1-2. Incentives for voluntary disclosure

Requirement 1: a) Companies compete with one another for financial capital in debt and equitymarkets. They want to obtain financing at the lowest possible cost. If investorsare unsure about the quality of a companys debt and equity securitiestherisks and returns of investmentthey will demand a lower price (higher rate ofreturn) than would otherwise be the case. Companies have incentives tovoluntarily provide information that allows investors and lenders to assess theexpected risk and return of each security. Failing to do so means lenders willcharge a higher rate of interest, and stock investors will give the company lesscash for its common or preferred stock.

b) Companies compete with one another for talented managers andemployees. Information about a companys past financial performance, itscurrent health, and its prospects is useful to current and potential employeeswho are interested in knowing about long-term employment opportunities,present and future salary and benefit levels, and advancement opportunities atthe company. To attract the best talent, companies have incentives to providefinancial information that allows prospective managers and employees toassess the risk and potential rewards of employment.

c) Companies and their managers also compete with one another in themarket for corporate control. Here companies make offers to buy or mergewith other companies. Managers of companies that are the target of a friendlymerger or tender offera deal they want donehave incentives to discloseinformation that raises the bid price. Examples include forecasts of increasedsales and earnings growth. Managers of companies that are the target ofunfriendly (hostile) offersdeals they dont want donehave incentives to

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disclose information that shows the company is best left in the hands of currentmanagement. Hostile bidders often put a different spin on the same financialinformation, arguing that it shows just how poorly current management has runthe company.

Requirement 2: Competitive forces from within the industry (i.e., other firms in the industry

are voluntarily disclosing information about order backlogs or customerturnover).

Demands by financial analysts for expanded or increased disclosure by thefirm.

Demands by shareholder activist groups such as CalPERS.

Demands by debt rating agencies such as Moodys and Standard & Poors.

Pressure from governmental regulatory agencies such as the Securities andExchange Commission. Firms may believe that disclosing certain informationvoluntarily may prevent the Securities and Exchange Commission frommandating more detailed disclosures at a later date.

Demands from institutional investors (e.g., mutual funds, pension funds,insurance companies, etc.) that hold the companys securities.

Requirement 3: The following examples are press release items that could be disclosedvoluntarily: forecasts of current quarter or annual earnings; forecasts of currentquarter or annual sales; forecasts of earnings growth for the next 3 to 5 years;forecasts of sales growth for the next 3 to 5 years; capital expenditure plans orbudgets; research and development plans or budgets; new productdevelopments; patent applications and awards; changes in top management;details of corporate restructurings, spin-offs, reorganizations, plans todiscontinue various divisions and/or lines-of-business; announcements ofcorporate acquisitions and/or divestitures; announcements of new debt and/orequity offerings; and announcements of short-term financing arrangementssuch as lines of credit. Other student responses are possible.

The advantage of these press releases is that the information is made availableto external parties on a far more timely basis than if disclosure occurred inquarterly or annual financial statements. Press releases also give managementan opportunity to help shape how the facts are interpreted.

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P1-3. Costs of disclosure

Requirement 1: a) Information costs include costs to obtain, gather, collate, maintain,summarize, and communicate financial statement data to external users.Examples are the cost of computer hardware and software, fees paid to auditfinancial statement data, salaries and wages paid to corporate accounting staffin charge of the firms financial accounting system, and costs to print and mailannual reports to shareholders.

b) Competitive disadvantage costs occur when competitors are able to usethe information in ways detrimental to the company. Examples includehighlighting highly profitable markets or geographical areas, technologicalinnovations, new markets or product development plans, and pricing oradvertising strategies.

c) Litigation costs are costs to defend the company against actions brought byshareholder and creditor lawsuits. These suits claim that information about thecompanys operating performance and health was misleading, false, or notdisclosed in a timely manner. Examples include the direct costs paid to lawyersto defend against the suits, liability insurance costs, loss of reputation, theproductive time lost by managers and employees as they prepare to defendthemselves and the company against the suit.

d) Political costs arise when, for example, regulators and politicians use profitlevels to argue that a company is earning excessive profits. Regulators andpoliticians advance their own interests by proposing taxes on the company orindustry in an attempt to reduce the level of excessive profitability. Thesetaxes represent a wealth transfer from the companys shareholders to othersectors of the economy. Managers of companies in politically sensitiveindustries sometimes adopt financial reporting practices that reduce the level ofreported profitability to avoid potential political costs.

Requirement 2: Student responses to this question may vary. One possible cost is whendisclosure commits managers to a course of action that is not optimal for thecompany. For example, suppose a company discloses earnings and salesgrowth rate goals for a new product or market. If these projections becomeunreachable, managers may drop selling prices, offer easy credit terms, oroverspend on advertising in an attempt to achieve the sales and earningsgrowth goals.

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P1-4. Proxy statement disclosures

The financial analyst might use the information contained in proxy statements inthe following ways:

1) To determine which members of the board of directors are outside versusinside directors. Outside directors are people that are not also employees ofthe company. Knowing how many board members are outside directors tells theanalyst something about board independence. Company executives are moreaccountable to an independent board, and the board itself is more effective atmonitoring the performance and decisions of top managers.

2) Information about the background of each board member helps the analystdetermine how knowledgeable and effective the board is likely to be inmonitoring the decisions and strategies of management. Do board membershave business experience, or are they celebrities and politicians who know littleabout the company and its industry?

3) Proxy statements report the share ownership of company executives andboard members. As their share ownership increases, managers personalwealth becomes more closely tied to the success of the company. As a result,they are more like owners when it comes to strategic decisions and operatingtactics. Managers with little (or no) stock in the company dont have the sameincentives to make sound business decisions.

4) Proxy statements help analysts understand management compensation(salary, bonus, stock options, and other pay components), and how much ofthat compensation is performance-based or guaranteed (salary). If a largeportion of managerial compensation is in the form of salary, managers havelittle incentive to work hard or create value for shareholders because paydoesnt depend on performance. On the other hand, if a large portion ofcompensation is in the form of bonuses or stock options, managers havestronger incentives to work hard and create value for shareholders because payand performance are linked.

5) The proxy statement also describes any changes that year in executivecompensation. Knowing how and why compensation has changed alertsanalysts to possible changes in managerial decisions.

6) Other student responses are possible.

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P1-5. Your position on the issues

a) Accounting is not an exact science. One reason this is the case is that manyfinancial statement numbers are based on estimates of future conditions (e.g.,future bad debts and warranty claims). Another reason is that there is no singleaccounting method that is best for all companies and situations. Thus, differentcompanies use different methods to account for similar transactions (e.g.,depreciation of property and the valuation of inventory).

b) While some managers may select accounting methods that produce the mostaccurate picture of a companys performance and condition, other managersmay make financial reporting decisions that are strategic. Consider the followingexamples:

Managers who receive a bonus based on reported earnings or return onequity may make financial reporting decisions that accelerate revenuerecognition and delay expense recognition in order to maximize the presentvalue of their bonus payments.

Managers who must adhere to limits on financial accounting ratios in debtcovenants may make reporting decisions designed to avoid violation of thesecontracts.

More generally, managers are likely to make financial reporting decisionsthat portray them in a good light.

The moral is that financial analysts should approach financial statements withsome skepticism because management has tremendous influence over thereported numbers.

c) This is probably true. Financial accounting is a slave to many masters. Manydifferent constituencies have a stake in financial accounting and reportingpracticesexisting shareholders, prospective shareholders, financial analysts,managers, employees, lenders, suppliers, customers, unions, governmentagencies, shareholder activist groups, and politicians. The amount and type ofinformation that each group demands is likely to be different. As a result,accounting standards in the United States reflect the outcome of a processwhere each constituency tries to advance its interests.

d) This is false. Even without mandatory disclosure rules by the FASB andSEC, companies have incentives to voluntarily disclose information that helpsthem obtain debt and equity financing at the lowest possible cost. Failure to doso results in higher cost of debt and equity capital.

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e) This is true. If the information is value-relevant, there is no obvious reasonnot to disclose except when doing so places the company at a competitivedisadvantage.

f) The best response is that the statement is false because:

Managers have incentives to develop and maintain a good relationship withfinancial analysts. Failing to disclose value-relevant information (good orbad) on a timely basis can damage this relationship.

Under the U.S. securities laws, shareholders can sue managers for failing todisclose material financial information on a timely basis. To reduce potentiallegal liability under shareholder lawsuits, managers have incentives todisclose even bad news in a timely manner.

g) This is false. Fundamental analysis is the detailed study of financialaccounting information for purposes of identifying over- and under-pricedsecurities. Financial statement information is essential to fundamental analysis.

h) This is false. Financial accounting information has value in an efficientmarket to the extent that it aids investors in the prediction of a firms systematicrisk (i.e., beta).

i) This may be true or false. If a company discloses so little information thatinvestors and lenders cannot adequately assess the expected return and risk ofits securities, then its cost of capital will be high. In this case, managers aredoing shareholders a disservice by not disclosing more information to financialmarkets. If, on the other hand, increased disclosure harms the companyscompetitive advantage, managers have helped shareholders.

j) This is false. Other sources include: industry-wide reports; analyst reportsabout the firm or its industry; governmental reports about macroeconomic trendsand conditions; and the financial statements of other firms in the industry.

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P1-6. How managers and professional investors rate information

The following is a ranking by the various company performance measuresbased on a 1996 survey done by Ernst & Young.

(Source: Ernst & Young Center for Business Innovation)

Importance Ranking Corporate Managers Professional Investors

Business Segment Results 4 7 Capital Expenditures 14 6 Cash Flow 2 2 (tie) Cost Control 5 4 Customer Satisfaction 3 11 Earnings 1 2 (tie) Market Growth 10 1 Market Share 13 5 Measures of Strategic Achievement 9 12 New Product Development 6 3 Product and Process Quality 7 13 R&D Productivity 12 9 Research & Development 11 8

Strategic Goals 8 10

P1-7 Accounting quality and the audit committee

1) By identifying the key business and financial risks facing the company, theaudit committee can ensure that those risks are properly disclosed in the MD&A(Management Discussion & Analysis) section of the annual report. A secondreason is that the answer(s) to this question might also flag areas wheresubjective accounting judgments and estimates are used in preparing thefinancial statements (see 2 on the following page).

2) By identifying areas where subjective judgments and estimates are used, theaudit committee can probe management about the quality (objectivity andaccuracy) of the estimates, benchmark to the estimates of other firms, andgauge the impact of estimate changes on the financial statements. Estimateduncollectible accounts receivable is a concrete example. Here the auditcommittee will want to know how this years estimate was determined, thereason for any change from last year, and how the estimate compares toestimates for other firms in the industry.

3) By identifying significant areas where the companys accounting policieswere difficult to determine, the audit committee can probe management aboutits choice of accounting methods in situations where GAAP may not provideclear guidance. This way the audit committee can uncover practices that might

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be overly aggressive or overly conservative in portraying the firms trueeconomic performance and condition.

4) Significant accounting deviations from usual industry practice are a red flagfor stock analysts and investors. Thats because the deviation is often viewedas an indication that the financial statements are being managed to look betterthan they should. The audit committee will want to probe management aboutthe reason for any deviation from industry practice, and gain confidence that thechosen practice more accurately reflects the economic fundamentals of thebusiness or transaction. The audit committee may also want management tobetter explain its choice of accounting practices in the annual report.

5) The answers to this question are important for the reasons outlined in 2above. They help the audit committee gauge the quality of the accountingjudgments (e.g., when to record revenue) and estimates (e.g., the uncollectibleportion of accounts receivable).

6) Changes in accounting methods can sometimes have a dramatic impact onfinancial statementsremember AOL?and on the companys stock price ifinvestors react negatively to the change. The audit committee will want toprobe management about the reason for the change, and gain confidence thatthe new accounting method more accurately reflects the economicfundamentals of the business or transaction. The audit committee may alsowant management to take special steps in communicating the change to themarketplace.

7) By identifying major transactions or events that required significantaccounting or disclosure judgments, the audit committee can ensure that thesespecial situations have been dealt with properly.

8) Here the audit committee is asking for a heads up about potential changesin accounting practicesboth those required by GAAP and those madevoluntarily by management. See 4 and 6 above for reasons why the auditcommittee might want to know about possible accounting changes in advance.

9) Serious problems can include incomplete documentation of transactions,errors (inadvertent failure to record a transaction), and accountingirregularities (intentionally booking revenue earlier than GAAP allows). Theaudit committee is interested in knowing about these problems because theycan signal accounting system weaknesses, lax internal controls, and culture ofdishonesty or deception that threatens management credibility and financialstatement integrity.

10) There are two reasons the audit committee is interested in the answer(s) tothis question. First, outsiders may have uncovered a real accounting qualitythreat that is as yet unknown to the committee. Second, the committee may

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want management to address outsiders concernsreal or imaginedso thatmanagement credibility and financial statement integrity remains intact.

11) The answers to this question can also uncover areas where accountingquality can be threatened. The committee will want to also hear from theauditor about the nature of the dispute and its resolution.

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Financial Reporting and Analysis Chapter 1 Solutions

The Economic and Institutional Setting for Financial Reporting Cases

Cases C1-1. AST Research: Restating quarterly results

The two situationsAST and America Online (AOL)have several things incommon: (a) the dollar amounts involved were large in absolute amount andrelative to reported sales and earnings; (b) the accounting change had nodirect cash flow impact; and (c) both accounting changes involved the SEC.

Why didnt investors penalize AST when its accounting change transformed$14.1 million of profits into an $8.1 million loss? One explanation is that ASTinvestors did penalize the share price, but they did so prior to the companysformal announcement of the accounting change on June 8, 1995. If investorscorrectly anticipated the AST accounting change and thought that it was badnews, the companys share price would have fallen before the June 8announcement date. (The same could have been true at AOL.) In point of fact,ASTs stock price had not declined during the weeks before its accountingchange was announced. When might you expect to see a negative share pricereaction to an accounting change like that made by AST or AOL?

When the firm is using a method that few other companies in the industryuse. Investors may mistakenly fail to adjust for the accounting differencewhen valuing the company. The accounting change alerts investors to thedifference and they accordingly revalue the firm.

Concerns are raised about the firms economic viability and its ability tofinance continued expansion. (Recall AST transformed profile into a loss!)Investors may lower the stock price to reflect less optimistic forecasts ofprofitabilty and growth.

The companys use of capitalization is described by analysts and thefinancial press as an attempt to manage its reported earnings. Theaccounting change may cause investors to question the quality of the firmsfinancial statements and managements commitment to shareholder value.

The AST accounting change seems, on the surface, to have resulted from asimple difference of opinion regarding acquisition accounting rules. There isnothing to suggest lower growth opportunities or questionable behavior on thepart of company managers.

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Some instructors may want to use this case to explore notions of marketefficiency.

How is the company doing today (May 1998)? AST Research reportedoperating losses in both 1995 and 1996. In April 1997, the company wasacquired by Samsung Electronics for $5.40 per share.

C1-2. Henley Manufacturing Inc. (CW): Announcing sales and earnings goals

Requirement A:

1) Potential costs of announcing earnings and sales goals include: (a) possibleshareholder lawsuits if goals are not met; (b) loss of reputation if goals are notmet; (c) disclosure may convey information to competitors about the profitabilityof products or market territories; (d) managers may make dysfunctionaldecisionsease credit terms, increase advertising expenditures, reduce R&Dexpendituresnear the end of the accounting period if it looks like the goals willnot be met.

Potential benefits include: (a) investors can better understand the risks andrewards of stock ownership because they know more about the companysplans; (b) disclosure may improve relationships with lead investors andanalysts, especially if its part of an ongoing communications strategy and notjust a one-time event; (c) investor and creditor uncertainty may be reduced,thus lowering the companys cost of debt and equity financing.

2) Should management disclose its earnings and sales goals? It depends onwhether the benefits outweigh the costs, and on how confident management isthat the goals can be achieved.

Easily achievable goals are likely to be disclosed without much reservation.Difficult goals are less likely to be disclosed because management may notwant to risk disappointing investors if results fall short of target. One way toavoid disappointment is to make the goals less specificfor example, salesare expected to increase by as much as 15% or sales are expected to be upsubstantially next year.

3) In all likelihood, the recommendation would change. Consideration wouldnow be given to the fact that, as the planning horizon increases, it becomesmore and more difficult to forecast accurately. For example, major changes inmarket-wide and industry-wide competitive conditions over the next two or threeyears could have a dramatic impact on whether or not the goals can beachieved.

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Requirement B:

In this case, the nature of the goals is quite varied. In all likelihood, investorsand financial analysts are going to be more interested in profitability and cashflow forecasts than in other financial aspects of the company. As a result, it seems reasonable to recommend disclosure of the following goalssubject tothe cost and benefit considerations mentioned earlier: annual sales growth of15%; annual earnings growth of 20%; a return on net tangible assets of 16%;a return on common equity of 20%; a minimum profit margin of 5%.

C1-3. Whirlpool Corporation (CW): Disclosing major customers

1) The SEC requires firms to alert financial statement readers about majorcustomers that contribute 10% or more to annual sales. This information helpsinvestors and analysts assess sales volatility and the potential impact onprofitability of the loss of a major customer. The information is especiallyimportant for companies operating in industries where competition forcustomers is intense.

2) Financial analysts might use these disclosures in the following ways:

To assess customer risk. The more revenue a company derives from asingle customer or small group of customers, the greater the adverse impacton profitability if one or more of these customers is lost to a competitor orsimply goes out of business.

By studying a firms major customers (i.e., the products they sell, expectedfuture demand for such products, untapped markets in other countries orgeographical areas), an analyst can determine the likelihood of increasedfuture sales to that customer and, hence, profits to the company.

3) The primary reason Sears monitors Whirlpools financial health is to ensurethat Whirlpool can be relied upon as a supplier of durable goods (refrigerators,air conditioners, washers, and dryers, etc.) to be sold at Sears. The buyer(Sears) wants to make certain that goods will be produced, delivered, andavailable in Sears stores when consumers want them.

Sears is likely to monitor the following aspects of Whirlpools operations:inventory levels, expenditures for research and development, overall profitability(i.e., the income statement), financial health and the mix of debt and equityfinancing (i.e., the balance sheet), and cash flow generating ability (i.e., thecash flow statement).

Whirlpool probably provides Sears with financial information beyond thatcontained in the companys shareholder financial statements. This additionalinformation might well include inventory levels for individual products,

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production lead times for various products, new products in development,features being considered for new products, and product improvements beingconsidered.

4) Whirlpool monitors the financial health of Sears to ensure that Sears will be acontinuing source of demand for its products in the future. Whirlpool is likely tomonitor the following aspects of Sears operations: inventory levels, sales,advertising expenditures, overall profitability, financial health and debt levels,and cash flow generating ability.

Sears may provide Whirlpool with information beyond that reported in itsshareholder financial statements. For example, additional information couldinclude days sales in inventory for Whirlpool products, market surveys resultsabout features consumers want to see in new products, and special promotionsthat will feature Whirlpool products.

C1-4. The gap in GAAP (CW)

1) Advantages of allowing managers some flexibility in the choice of financialreporting methods include:

Accounting must serve as a slave to many masters. Stated differently,financial accounting information is used for many purposes includingvaluation, credit analysis, and contracting, and there is no reason to believethat a single set of financial reporting methods would serve each of thesepurposes equally well. By allowing managers some latitude in the choice offinancial reporting methods, they can weigh the trade-offs implicit in makingthe firms financial reporting data informative for each of these potential uses.

If managers have some latitude in their choice of financial reporting methods,they can adapt the firms financial reporting practices to changes in the firmseconomic characteristics and/or environment over time. For example, achange in the rate of technological advance in a firms industry may meanthat new long-term assets should be written off at a faster rate than waspreviously the case. Assuming the firm had been using straight-line, achange to an accelerated depreciation method might be optimal, assumingthat managers want the numbers reported in the income statement andbalance sheet to present the most accurate picture of the firms economicenvironment.

2) The current financial reporting system in the United States is really acombination of the two approaches.

On the one hand, firms have latitude in the selection of accounting methods tosummarize various transactions and events. Examples include inventoryvaluation where firms may select from LIFO, FIFO, or weighted average;

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depreciation policy where they may select from straight-line or acceleratedmethods such as sum-of-the-years-digits or declining-balance methods; andaccounting for oil and gas exploration costs where firms may apply the full-costor the successful-efforts method.

On the other hand, there are numerous cases where the FASB (or SEC) hasmandated a single accounting method or treatment for various transactions orevents. Examples include research and development expenditures which mustbe expensed in the year incurred; leases which must be capitalized andreported as liabilities on the balance sheet if certain criteria are met; accountingfor foreign currency translation; and accounting for pension benefits and otherpostemployment benefits other than pensions.

3) The advantages of a single set of accounting methods include:

Facilitates comparability of financial information across firms at a point intime and over time. This may be appealing to financial analysts because itpotentially makes their work easier.

Ease of verification by the auditing profession. Might lead to fewershareholder lawsuits and suits against auditors for aggressive financialreporting decisions made by managers. External auditors may find theease of verification beneficial to them.

The disadvantages of a single set of accounting methods include:

Assumes that the financial performance and condition of all firms canadequately be captured by a single set of accounting methods. Implicitlyassumes that firms are homogeneous. Moreover, that all firms haveidentical economic features and characteristics and face identicaleconomic environments.

Assumes that a single set of accounting methods serves all the potentialuses of financial statement information (e.g., valuation, credit analysis, andcontracting).

The advantages of allowing some flexibility in the choice of financialreporting methods include:

Firms can tailor their choice of financial reporting methods to the specificaspects of their economic environment and circumstances. For example,depending on whether the prices of its input products is increasing ordecreasing, FIFO may be a more realistic choice of inventory valuationmethod for income determination purposes when compared to LIFO (orvice versa). As another example, in industries where long-term aspectsare subject to a rapid rate of technological advance and change,

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accelerated depreciation methods may be superior for incomedetermination purposes when compared to straight-line (or vice versa).

The disadvantages of allowing some flexibility in the choice of financialreporting methods include:

May detract from making comparisons across firms at a point in time andover time.

Managers may use their discretion over reporting methods to distort thefirms performance. They might adopt financial reporting practices thatcreate the appearance of profitability in an attempt to hide or cover up pooroperating performance. They might also adopt financial reporting practicesthat accelerate the recognition of revenues and delay the recognition ofexpenses in an attempt to maximize the present value of payouts frombonus plans tied to reported profitability.

C1-5. IES Industries: Voting on a merger

Requirement 1: As an employee-stockholder, two issues would seem to be of most concern:Which dealthe three-way merger or the takeoverwill have the mostfavorable impact on share value and on my continued employment with thecompany? Because only 100 shares are owned, most of the employeesconcerns are likely to focus on job issues.

What plans do the merger partners have for reducing the workforce at thethree companies? What jobs are likely to be affected, and what severancebenefits will be offered? How will positions in the merged company be filled?

Why didnt the IES share price increase following announcement of thethree-way merger? Does this mean that there are no benefits to IESshareholders or employees?

What will happen to my job if MidAmerican buys IES? The extra $500 I willreceive from a MidAmerican buyout (100 shares $5 per share) seemssmall in proportion to my employment risk.

IES financial statements are not likely to be of much help in answering thesequestions. The merger prospectus probably identifies key areas of duplicationand, thus, may shed some light on where cost savings are likely to befoundbut the prospectus will not say much about specific jobs. Nor willMidAmerican say much about possible job reductions at IES because to do sowould lessen its chance of receiving a favorable vote from IES shareholders(some of whom are employees).

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Requirement 2: Most institutional investors own stocks for the long term. Historically, utilitystocks are held because they have little risk (regulated monopoly) and predictable dividends. This implies that the institutional investor will beconcerned about long-term value (share price appreciation) and dividends in anincreasingly competitive environment. Questions might include:

How will the combined companies position themselves for an increasinglycompetitive energy environment? What specific plans does managementhave, are they realistic, and will the combined companies have thecapabilities to execute those plans?

How will the three-way merger affect dividends? Are the three companiesgenerating excess operating cash now, what are they doing with that cash,and how will that change as competition increases?

Why didnt the share price of IES increase when the three-way merger wasannounced? What is the market saying about merger benefits to IESshareholders?

How would MidAmerican position itself for an increasingly competitiveenergy environment? Which strategy seems to hold the most promise?

What will MidAmerican do about dividends? Is it generating excess operatingcash now? If so, whats being done with the money?

What specific cost reductions and redundancies have been identified? Arethe estimated cost savings realistic? What is the timetable for capturingthose cost reductions?

Company financial statements will prove to be of some help in answering thesequestions, particularly with respect to excess operating cash flows and futuredividends. It will also be the case that an institutional investor with 5%ownership will be the target of proxy solicitation attempts by both sidesthemerger partners and MidAmerican.

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C1-6. Trans World Airlines (TWA) (CW) Earnings announcement

For discussion purposes, here are some useful comparisons between 1992 and1993 ($ in millions).

____1993____ ____1992____ Net income (loss) $ 623.8 ($317.7) Gain on debt retirement 1,080.0 0 Pre-gain loss1 (451.8) (317.7)

1 (623.8 - 1,080.0) = -456.2 is not equal to the -451.8 million TWA reports in the article. The differenceprobably reflects some additional credits that TWA does not separately break out in the article.

Operating income before taxes, misc. credits, and charges ($ 281.3) ($404.6) Revenue (decline of 13%) 3,160.0 3,630.0 Load factor 63.5% 64.7%

There are several things that you might tell your father, almost all of which arebad news.

The bad news: TWA was not really profitable in 1993. The one-time gain from debt

retirement increased reported income by $1,080.0 million, but had no impacton TWAs cash flow. Perhaps more importantly, this income is not arecurring source of sustainable earnings that TWA will earn year in and yearout.

The gain arose because TWA exchanged debt whose face amountexceeded the equity shares that were issued. The transaction was part ofTWAs bankruptcy process and its negotiations with creditors.

To see the effect of this transaction more clearly, consider the followingjournal entry:

DR Various bonds/LTD $XXX Various notes XXX CR Stockholders equity $XXX Gain on retirement of debt 1.08 Billion

TWAs pre-gain loss for 1993 was much larger than in 1992 (i.e., $451.8million versus $317.7 million). This means that, before considering the debtretirement gain, TWA was even more unprofitable in 1993 than it was in1992.

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Revenues fell by 13%, although part of the reason for the drop is that itappears that TWA reduced airline service in some markets.

TWAs load factor (percentage of seats filled on a given flight) fell by over1%.

The good news: The loss before taxes, misc. credits and charges decreased from $404.6

million in 1992 to $281.3 million in 1993. Of the numbers reported in thearticle, this item probably comes closest to a measure of TWAs ongoing(sustainable) income. The fact that it is negative is not good, but the fact thatit improved from the prior year means theres hope. It would be important foran analyst to investigate the nature of the misc. credits and charges thatwere made in 1992 and 1993. This would enable the analyst to make a moremeaningful comparison of the numbers TWA reports for loss before taxes,misc. credits and charges.

The bottom line: Not all earnings are created equal! The large gain TWA reported in 1993creates the illusion of profitability, when, in fact, the company is still operating ata loss.

What should you tell your father? It seems clear that based on current yearresults, your father should not expect TWA to begin paying dividends, restoreany pilots wage concessions, or to purchase any new aircraft.

C1-7. Landfils accounting change

Its consistent with GAAP and fully disclosed. While true, this approachmay not be comforting to analysts and investors concerned about whethercapitalization makes the company look more profitable than it really is. Giventhe steep price decline at Chambers Development, analysts and investorswill be scanning their radar screens for other capitalization companies, andthey will surely discover Landfils accounting. Unless capitalization can bestrongly defended, the companys share price is likely to fall.

We capitalize, and were proud of it! The heart of this strategy is the notionthat the company has already made the correct accounting decisiononethat fairly portrays the profit performance and asset base of Landfil. Ifinvestors and analysts can be convinced, continued use of capitalizationshould not result in a share price declinebut can they be convinced?

We can afford to change. Even if capitalization is the best (mostappropriate) accounting method for Landfil, it still might be advantageous tochange. First, a change to immediate expensing will dispel any remainingskepticism on the part of investors and analysts. Second, it demonstrates

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managements confidence in the companys prospects and its ability toabsorb the dollar impact of the change. But this strategy is riskyinvestorsand analysts may incorrectly presume that capitalization was being used tomanage reported earnings. This may cause them to question thecompanys other accounting methods and the quality of its financial reports.

C1-8. AstroText Company: Questions for the stockholders meeting

Requirement 1: An employee shareholder might be interested in the following sorts ofquestions:

Why is AstroText willing to pay a $7 per share ($21 million) premium forTextTool?

How will the premium be financedoperating cash flows, debt, stock, or thesale of TextTool assets?

What impact will the premium and form of financing have on the value of myAstroText shares and stock options?

How will the acquisition premium affect our ability to maintain or increase ournew product R&D?

How will my job be affected by the merger/acquisition?

The financial statements of both companies could shed light on some of thesequestions. For example, we could learn if cash balances and operating cashflows are sufficient to finance the transaction. We might also uncover significantnon-operating assets that could be sold to raise cash. R&D spending patternsmight suggest financing concerns or indicate redundancies that could beeliminated. SG&A cost comparisons might also identify redundancies that couldbe eliminated.

The employee-shareholder has two concerns: What will happen to the value ofmy shares and options, and will I still have a job? Neither question can be fullyanswered by analyzing company financial reports but the reports will shedsome light on the questions.

Requirement 2: The lead banker for AstroText will have two concerns: How does the proposedtransaction affect the risk of loans currently placed with the company, and whatare the long-term prospects for the combined companies? Specific questionsmight include:

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How will AstroText finance its acquisition of TextTool, and will the transactionincrease the credit risk of loans we now have with AstroText?

Does the acquisition require lender approval, and, if so, should we approvethe transaction?

How has TextTool been financing its activities? Who is the lead bank, and dowe have an opportunity to increase our business as a result of theacquisition?

What financing needs will the combined companies have going forward, andhow can we help structure credit facilities consistent with those needs?

Will either company be selling assets as part of the transactions? If so, whichassets and for how much? How will the proceeds be used?

Company financial statements will prove to be quite helpful to the lender.TextTools report will outline its current lending agreements and may evenidentify its lead banker. This will help identify the competition for future business.The combined cash flow statements will help the lender determine if credit riskhas changed. This analysis, coupled with information from management aboutfuture plans, can also help uncover new business opportunities.